Fed Watch: Policy Adrift

By Tim Duy · Nov 20, 2008: I understand the Federal Reserve Chairman Ben Bernanke is considered something of a sacred cow, our one point of light in an uncertain world. An academic who cannot be questioned by other academics. A smart person who has mastered the Great Depression and therefore “knows” what to do, and is providing the leadership to do it.

I am beginning to question all of these assumptions.

I am hoping Bernanke can step forward and clarify the direction of policy. At this moment, he has the best perch from which to guide policy between administrations. He has the opportunity to show leadership. But for now, I see a distinct lack of leadership from the Federal Reserve, and it suggests that Bernanke has used up his bag of tricks. And I don’t think that he knows what to do next. Indeed, Fedspeak is now littered with confusing statements that leave the true policy of the Federal Reserve in question.

First, policymakers appear uncertain about what to do with the Fed Funds target. The minutes of the most recent meeting tell the story:

Some members were concerned that the effectiveness of cuts in the target federal funds rate may have been diminished by the financial dislocations, suggesting that further policy action might have limited efficacy in promoting a recovery in economic growth. And some also noted that the Committee had limited room to lower its federal funds rate target further and should therefore consider moving slowly. However, others maintained that the possibility of reduced policy effectiveness and the limited scope for reducing the target further were reasons for a more aggressive policy adjustment; an easing of policy should contribute to a beneficial reduction in some borrowing costs, even if a given rate reduction currently would elicit a smaller effect than in more typical circumstances, and more aggressive easing should reduce the odds of a deflationary outcome.

Considering the forest of trees killed in studying the Japanese experience with ZIRP, one would have imagined that the Fed had already answered the question of how low can they go with the target rate. The answer is zero, and they will head there because they need to look like they are doing something. And we already know that that next 100bp are meaningless in support of economic activity; Jim Hamilton persuasively explained why this is the case here and here. Simply put, debates about the Fed Funds target are nothing more than academic masturbation. I can only imagine the flurry of memos flying around Constitution Avenue as staffers debate the last 100bp as if it was meaningful from a policy perspective. Just cut to zero. Stop the madness already and let the Fed staff go home to see their families.

With the Fed Funds target effectively a nonissue, policy needs to take a different direction. And here again I am supremely perturbed by Fedspeak as policymakers throw around the term “quantitative easing” as if it were candy on Halloween. The minutes seem to make clear that quantitative easing is not the current policy. There is no mention of the quantitative easing in the minutes themselves. The only mention is in the forecast summary:

Some participants noted that further monetary policy easing could eventually become constrained by the lower bound of zero on nominal interest rates, in which case an elevated degree of uncertainty might be associated with gauging the magnitude and stimulative effects of other policy tools such as quantitative easing.

It appears to make clear that the Fed has not yet officially initiated quantitative easing; it is relegated to the status of “other policy tools.” Indeed, no target has been announced. Nothing to the effect of “we are going to make unsterilized purchases of Treasuries until the rate on the 10 year bond declines to x%.” Or “we are making $xx billion of unsterilized bond purchases each week until the policy objective xx is achieved.” Those are explicit quantitative easing policies. What we have now is an expansion of the balance sheet to accommodate liquidity measures. This may pave the way to quantitative easing, but still maintains the Fed Funds rate as the primary target.

But then why do they keep saying they have a policy of quantitative easing? This first crossed my radar when reviewing a recent interview with Dallas Federal Reserve President Richard Fisher. I discounted his reference to quantitative easing as Fisher is something of a colorful character who often talks before he thinks. But subsequent policymakers repeated the term. Earlier this week New York Fed President Gary Stern was quoted by Stephen Beckner:

Asked whether the doubling in size of the balance sheet represents “quantitative easing,” Stern said “I don’t think that’s a bad statement. I think the world is a little more complicated than that, but I don’t think that’s a bad statement.”

Meanwhile, Kohn added that the Fed has “already” engaged in forms of quantitative easing, and “we should be looking carefully” at the effect that could have “as a contingency plan should that still-remote possibility, but I think less remote than it was, occur.” … He said the Fed hasn’t abandoned monetary policy in favor of quantitative easing, noting the Fed’s recent reduction in its target federal funds rate. “I don’t think we’ve given up on one in favor of the other,” Kohn said. He also said there’s no “arithmetic” reason why the Fed can’t “blow up” the size of its balance sheet, which has already swelled in recent weeks to over $2 trillion.

Apparently what Fed officials think is that they 1.) already engaged in quantitative easing, 2.) doing something like quantitative easing, or 3.) might be doing quantitative easing or interest rate targeting, but are not sure which. One can only conclude that Fed officials do not understand their own policies. Policy is adrift. Be afraid; be very afraid.

Mark Thoma also points us to Rebecca Wilder, who points us to former St. Louis Federal Reserve President William Poole. Poole suggests that the Fed has already committed to quantitative easing,

William Poole … accuses the Fed of not being transparent and shifting monetary policy without announcement. Although he does not speculate as to what the new policy is, he does state that by not announcing its new policy, the Fed is breaking the law.

According to Poole: “Something is happening at the Fed that has not been announced.”

Could the Fed really be hiding a policy shift in some bizarre attempt to generate an unanticipated positive shock? If so, yet another forest of trees was killed to disseminate research on the importance of transparency in policymaking, only to have that research ignored by the policymakers who wrote it.

Ironically, I would be somewhat comforted to learn that the Fed does have a coherent, albeit unannounced, policy change. The alternative is what I suspect – Bernanke cannot elucidate a coherent policy strategy to his organization because no such strategy exists. What does exist is a potpourri of policy responses that amounts to providing liquidity at all costs, the outcome of Bernanke’s research on the Great Depression. Beyond this, the Fed is stuck in a netherworld of dual policy targets – not ready to admit the loss of the interest rate target, not ready to adopt a formal policy of quantitative easing.

Moreover, what is absolutely maddening is that Bernanke had an opportunity to dictate a course of policy that had some hope of bringing resolution to this mess – the now dead TARP. While Treasury Secretary Henry Paulson is rightfully criticized for his erratic policy choices, remember that Bernanke was Paulson’s handmaiden throughout the process. Recall Paul Krugman:

So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into the pot because that will let us find the true values of troubled assets, which are higher than the fire sale prices out there, and so balance sheet will improve, confidence will return, etc, etc..

So I just did a Nexis search trying to find out when Paulson and Bernanke started talking about price discovery, which we’re now told are at the core of the plan’s logic. And the answer is …

Yesterday.

I can’t find any use of the term, or even a hint of the argument, until yesterday’s Senate hearings.

One possible explanation. It wasn’t until yesterday that they realized that it would actually be necessary to explain themselves.

But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this stuff about price discovery is an after-the-fact rationalization, invented when people started asking questions.

It has seemed very strange to me that such a supposedly crucial economic program would be based on such an exotic argument. My sneaking suspicion is that they started with a determination to throw money at the financial industry, and everything else is just an excuse.

This attempt at financial engineering, using auctions to allow “price discovery,” could only have come from an economist who spent more time dealing with equations than people. Unnecessarily complicated.

I think that the basic element of the original TARP plan – the removal of bad assets from the financial system – was a part of an appropriate policy path, but needed to be combined with equity stakes and recognition that the taxpayer would likely bear a cost. For example, the Treasury purchases mortgage assets at a high price, thereby recapitalizing the financial firm. In return, the Treasury receives an equity stake that dilutes that of existing shareholders to zero. Replace existing boards and top management; bar management from future employment in financial services. Treasury then auctions off the troubled assets into the financial markets (just forget about managing the portfolios until prices recover; let the assets reenter the system at a price that almost ensures an upside). The taxpayer eats the difference, but will be at least partially compensated in the future when the Treasury floats the equity stakes back into the market. This process is legislatively dictated; financial firms who hope to be allowed to continue to operate in the US would be effectively forced to participate.

To be sure, I make no promise that the taxpayer will walk away clean, but compared to the risk that the financial sector hobbles along forever, it would be a reasonable cost. Instead, the Treasury, apparently with the Fed’s blessing, use the TARP options of equity infusion (forced onto Paulson and Bernanke), and did only a portion of the job with a partial recapitalization. The nonperforming assets remain trapped in the system, threatening to create zombie banks. Bernanke might not be making the same mistakes as the Fed in the Great Depression, but it is starting to look like he is not willing to fundamentally address the problem of sour assets. Doing just enough to keep banks alive looks a lot like a mistake made in Japan. I am surprised that New York Federal Reserve President Timothy Geithner would accept such a plan; he understands Japan’s lost decade as well as anyone.

I think it is high time some real critical attention was placed on Bernanke. How complicit was the Fed Chairman with designing and implementing a clearly failed policy? Yes, one could argue that the ball was in Treasury’s court. But didn’t Bernanke have a duty to make TARP work, after he begged Congress for the plan? And isn’t he the one person who could stand up and say “No, Paulson is screwing this up”? Paulson will not be Treasury Secretary in January, but Bernanke will still be Fed Chairman. Bernanke can and should step into what is so clearly a leadership void. What does he owe this administration at this point?

In short, we need policy leadership. Bernanke is positioned to provide it. But will he? As of now, policy is adrift. FOMC members don’t seem to agree on the role of effectiveness of the Federal Funds target. Some think they are already engaged in a policy of quantitative easing. Some think they may be in something that looks sort of like quantitative easing. Kohn seems to think they are following two policies. Ex-FOMC member Poole is certain that they are hiding a policy change. In the meantime, while Fed officials publically debate the intent of their own policies, investor confidence is collapsing. Bernanke needs to step forward and define policy. We need to pressure him into providing that leadership – or to step aside for someone else to do it.

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

4 Comments on Fed Watch: Policy Adrift

The money supply can never be managed by any attempt to control the cost of credit.

Managing interest rates (in the short run) is antithetical to the noninflationary management of the money supply – and that in the longer term we have not only higher rates of inflation but higher interest rates as well.

Interest rates are not the price of money. the “price” of money is the reciprocal of the price level. It was this confusion that led to the assumption that interest rate manipulation could achieve the proper level and rate of growth in the money supply.

I.e., Alfred Marshall, the Cambridge economists, is responsible for developing the cash-balances approach to money. For example, if individuals collectively desire expanding their cash balances (increasing the period over whose transactions purchasing power in the form of money is held), they will initiate a chain of events which will lead to a net reduction in their aggregate holdings of cash.

That is, an over-all increase in the demand for money leads to falling prices, a decline in profit expectations, reduced borrowing from the banks — and therefore a smaller volume of cash balances.

Money thus is truly a paradox – by wanting more, the public ends up with less, and by wanting less, it ends up with more. All motives which induce the holding of a larger volume of money will tend to increase the demand for money – and reduce its velocity. Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.

The significant economic purposes for which a debt was contracted, or the manner in which it was financed, is of inestimatable value in evaluating it’s impact.

For example if the debt was acquired to finance the acquisition of a (new-security), the proceeds of which are used to finance plant and equipment expansion, rather than the purchase of an (existing-security) to finance the construction of a new house, rather than to finance the purchase of an existing one (as will Paulson’s planned $700 bill bailout), or to finance (inventory-expansion), rather than refinance (existing-inventories).

The former types of investment are designated as “real” as contrasted to the latter, which constitute “financial” investment (existing homes).

Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy. Compared to real investment,it is rather inconsequential as a contributor to employment and production.

Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.